Rahul Deodhar's Blog, page 25

Austerity not a medicine for all occasions

One of the key lessons of the great depression is that austerity is not a medicine for all occasions. However, over the subsequent excesses we seem to have lost out on this learning.

Austerity is not a solution for USThere is hardly any doubt about ability of US to compete. In fact, if the fat corporate balance sheets are to go by, US companies are in their best shape among past 5 years. Yet, the unemployment numbers are languishing which makes US a pump needing priming. Such priming will be achieved through a jobs program to create next-gen infrastructure that will allow US manpower to compete in knowledge era. Austerity, in this case, will impair future competitiveness. However, the kind of priming as envisioned in the Fed's quantitative easing program is nothing but wasteful. These programs do not have well established working channels to reach fruition. 

Greece and wasting water priming the pumpWe don't waste water priming the pump so long as the pump works and there is water at the end of the well. In case of Greece, both parts seem to be a problem. In such case, austerity is a better alternative till the economic engine is repaired. Further, Greek government must set in place tax reforms allowing fair and easy collection of taxes. Once such necessary conditions are in place, then Greece will need a spending program to kick start growth in a sustainable manner.

Implications for markets and democracyThe problem with misunderstanding related to austerity is two-fold. The problem with austerity is that it will wreck havoc with asset prices in general impairing genuine investment leading to future problems. The second problem is the people's confidence in the system is shaken leading to anarchy and threat to general system of law and order. In short, the cost of misunderstanding austerity will be massive.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Geoffrey West on corporation and cities onEdge.org

My day was made when I read the edge piece today. Geoffrey West, professor, talks about interesting aspects of Why Cities Keep Growing, Corporations And People Always Die, And Life Gets Faster.

As an investor, company life-cycle represents a lesser-debated frontier. Analysts tend to rely on the accounting view of going-concern. Yet, the permanence we take for granted is a mirage. However, understanding when the decline of the firm comes about is easier said than done. 

Dr. Geoffrey West points to yet unpublished (and still being verified) work that says firms scale sub-linearly. In other words as firms get bigger, they become less profitable and they eventually perish. Compare this with cities (which he discusses before firms) that grow super-linearly. In other words as cities get bigger, they become more beneficial for its inhabitants. So then, should investors stop companies from growing? And how should one view the increase in scale. 

I think as investors it highlights a very important and much neglected area.






My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Wary of QE2 withdrawal effects!

At a time when Indian markets were nearing valuation comfort, they surged again. Usually, it would be a positive reinforcement and time to get in. However, I am not sure today. The risks arising out of end of QE2 pose significant threat to markets.

On its own, the end of QE2 alone would be a perceptible trigger. But more important is the situation of world economies at this point. With EU on the brink of another crisis, waning strength of US recovery and still-to-gain-traction Japan, we are at the most unstable point in recent years. At such a time a withdrawal of QE from US may not auger well for the markets. 

I guess we must hold on tight and keep powder dry for there may be interesting times to invest in very near future. 




My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Krugman & Delong and Weak Dollar

Brad Delong links to the Krugman post titled A Weaker Dollar Is in America's Interest. I have always maintained that weaker dollar is essential for US economy to recover. Weaker dollar has come about using a different mechanism that investors anticipated.

The value of any currency refers to or is derived in relation to a basket of goods. The basket has significant number of commodities. So as investors moved the commodity prices up, the value of the US dollar automatically depreciated. In other words, investors created this devaluation and not the central bank.

The process, however, is fraught with risks. In a world of pegged currencies, we now have devalued the entire currency universe. This, to my mind, is not correct. The purchasing power of other currencies, particularly the Yuan, should be higher. The discrepancy has crept in because of central bank action. Developing countries are worried about export competitiveness declining with even small appreciation in currency. As a result they have to tolerate higher inflation and no amount of domestic slowdown may correct it. Only those countries that have strong economic transmission mechanisms can tolerate inflation. However, this is only short term relief. As transmission mechanism takes effect, it translates into higher wages and thus lower competitiveness.

With the Chinese reserves topping USD3 trillion, I guess we have some more time. I had mentioned in an earlier posts that it will take doubling of Chinese reserves till we have decisive action. At the time Chinese reserves were close to USD 2 trillion. So I am expecting this process to continue for some more time in accordance with the phases I mentioned back in video (relinked below) in 2009.



USD Dollar Views from 2009(links to old post)




My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Commodity markets and synchronized investment

John Kemp has a piece on the financial post titled Analysis: Commodity markets wobble | Investing | Financial Post. He argues that prices have diverged from fundamentals and talking heads are merely retrofitting explanation to reality.

Broadly, I want to add that such trend build-up is seen in many asset classes. The bubble-like behavior needs a sustained up move and as the move loses momentum, downward forces take effect. The downward action, in most cases, is swift leaving many (occasionally including yours truly) in the lurch.



I believe this is as much a result of group think as speculation. Algorithm-based trading, herding aided by technology (mass-emails) and lack of diversity of ideas probably causes synchronized money flows resulting in self-reinforcing behavior. Some fund managers interested in exploiting this behavior often talk about leading such trends or buying stocks not companies.



A typical trend comprises of four phases accumulation, discovery, bull-run and realization. Accumulation happens when prices are low for sustained period of time. At such times a section of population accumulates the assets leading to firming of its price. The group is led by fundamental investors and many others follow suit. Discovery happens as more and more people realize the downside resilience of the prices of that asset. Technical charts start suggesting potential for up-moves. Early speculators jump on the bandwagon and soon this phase moves into a bull-run. In bull-run the prices start accelerating, crossing the targets investors have in mind, but the move shows no signs of abating. The prices soon reach the bubble territory and often confidently march on prompting investors to re-look at fundamentals to see if they are missing something. As prices cross the bounds of incredulity, realization dawns about weak fundamentals and all the hell breaks loose. The synchronized move out of the asset creates more distress to prices that warranted by fundamentals.



While I am critical of this issue, the issue itself is not new. Such behavior is a reality of the market. It is merely exposed more during volatile times. In periods of stability the trends hide this behavior from public scrutiny.

Volatility and investments

As the markets are getting more volatile by the day, we turn our focus to impact of this volatility. In general, volatility is enemy of long term investment. It is a friend of aggressive trader when luck is favourable. It promotes, a sort of, alignment towards short term.



Current macro climate in India is sensitive to such short-term focus. India needs long term investments that should boost supply to accommodate the growing demand. Such investments are are difficult to conceive during times of high volatility. The attempt of policy-makers should be to create pockets of certainty in areas that can be controlled. Particularly, monetary policy, fiscal policy and government regulation need to demonstrate continuity and stability thus not contribute to the already existing volatility.



China has successfully shown policy continuity and stability that promotes such investment. India needs to learn from China in this regard.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Super Boom - 500% increase in stock prices

Barry Ritholtz comments on plausibility of Jeff Hirsch's Super Boom: Why the Dow Jones Will Hit 38,820 and How You Can Profit From It | The Big Picture. As Barry mentions, it is plausible. However, timing the bottom still remains a challenge.

I believe there were trends ready to take over during episodes Jeff points to. There was the automobile boom, suburban boom and consumer products boom, the internet and computing boom etc. The problem is, as of now, I do not see any sector ready to create the growth momentum required for 500% increase in stock prices. I was looking at alternative energy among other things, but it doesn't seem to be a big contender as yet.

For a sector to be an able contender to create (not simply augment or drive) growth momentum it needs a few qualities. It needs to be a mass employer at a value-chain level. It needs to create productivity gains in existing economic engine while creating ancillary products and services that are growth engines in their own right. The first past will help finance investments in the technology while the second will create exponential gains in the sector both in terms of adoption and profitability.

Alternative energy cannot, as yet, be a mass employer. Though it can create energy independence and help the economic engine. To be specific, I think the sector has the potential to become a top trend creator in 10 years time. Another sector in its infancy could be water management and treatment. In my view, healthcare services or healthcare delivery services as industry fellows call it, may be a reasonable bet. I do not have much conviction in the idea as yet, but it ticks off some important boxes. It can be a mass employer, it will help improve productivity of economic engine (by keeping labour employable), it is a critical need so funding should not be an issue. The missing link is the exponential take-off. Unless people come up with innovation, I do not see exponential take-off materializing easily.

In all probability, the identification of trend should take at least couple of years. Till such time I do not see the beginning of the 500% trend. However, I am convinced that once such a trend is in place, we will see a period of sustained growth as the trend propagates through the global economy and benefits begin to stabilize. I am not sure if the percentage 500% is relevant but a sustained growth is always welcome. So let us hope for a quick revival!





My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Good debt and bad debt

Michael Pettis clarifies the difference in his post Reforming the banks.

The relevant paragraph reads:

The reason debt levels always seem to grow unsustainably, I suspect, is that in the initial stages of the growth model much if not all of the investment is economically viable as it pours into building necessary infrastructure whose profits and externalities exceed the cost of the investment. The result is real growth. At some point, however, the combination of subsidies, distorted incentives (in which investment benefits accrue to those making the investment while costs are shared broadly through the banking system), and very cheap financing costs leads inexorably to wasted investment and debt rising faster than asset values. This is when the debt burden begins to rise in an unsustainable way.

This explanation points to a difference between productive and unproductive debt that we discussed in earlier post. Productive debt creates an asset of higher value than itself. Let us highlight this sentence:

Productive debt creates an asset of higher value than the debt itself.

Please refer to the causality, critical to the equation. With housing, the sentence was correct except for the causality. The causality in housing was reverse - it was higher housing prices that were creating debt not other way round.

Snippet: What is a risk-free return?

In this snippet I restrict the question to investment firms and investors. These firms and investors get capital at some expected rate of return. Thereafter, the firms use their knowledge and management skills to generate returns  on this capital. Ideally, the returns they generate are higher than those expected by providers of capital. Further, and let us read this carefully, the returns these firms generate are higher than returns they could generate through any other activity.

In such cases, Risk-free return is rate of return slightly higher than cost of capital for these firms.



Your comments?

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Crisis and plight of common man?

John Mauldin describes a letter sent by one of his readers. The reader, Bill, asks why is it that economists and analysts are promoting austerity implying pain for the common man. He particularly points to capitalism working for "have-gots" rather than the common man. John Mauldin answers well but I would like to add a few points.

The crisis is a problem for "have-gots" but the correct have-gots are ones who have got the debt. It is debt that is the problem for common person, not job or income. Somehow, we must realize that the mechanics of debt is not properly explained to the lay-person. Debt is good if it creates something that can repay the debt - a production asset. The collateral is just to allay the fears of the lender. Some how we created debt for assets that did not generate returns to repay the debt - like housing. These are, in my book, consumption assets and not production assets. 

The future for those with unpaid debt is bleak. Further, those who do not have enough savings, are likely to suffer next. To get through this phase of economic consolidation we need people to have strong backing of savings. These are usually the rich people, but this also includes those who were prudent with their money.

The question of austerity and jobs, to my mind, are mixed up. We need austerity in programs that are wasteful. However, constraining job-creating projects under the name of austerity is not a right remedy. Jobs are what will get the economy out of the woods.

The question, therefore, is why is there no job recovery. My sense is that we are undergoing a phase transformation in terms of employment profile of the economy. This is, in many ways, what Alwin Toffler calls "waves". The first wave created an agrarian-dominated employment profile. The second wave created a factory work-dominated profile. The third moved the profile to services and within services to technology driven services. We are awaiting the fourth transformation.

The problem with phase transformation is that individuals are often well-versed in older wave skills rather than new wave skills. To change this, we require extensive training and education. However, before we begin training, we need to know what the wave is. To survive this period of uncertainty we need savings and monetary solidity. The common person, almost always, does not have this. The dilemma, therefore, is how to assist the population while we determine what the next wave will be.

As a solution for this problem, Keynes suggested creating any job, even digging and filling ditches will do. Such a program goes against the principle of austerity. However, to my mind, Keynes' solution about  job creation represents way out.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.